An option is a contract that represents the right to buy (call option) or sell (put option) a specified amount of an underlying security at a predetermined fixed price within a specified time period. The underlying securities typically are shares of stock or exchange-traded funds, securities indexes, bonds or foreign currencies. The fixed price or “strike price” is the price at which the underlying security can be purchased, in the case of a call option, or sold, in the case of a put option.
The purchaser or holder of an option pays a premium for the right but not the obligation, to exercise the option contract. At expiration, the option becomes worthless. Option sellers assume a legal obligation under the option contracts to fulfill the contracts if the options are assigned to them, whereas the premiums are the extent of the potential risk to option buyers. Options lose value with time—known as “time decay”—which is priced into the premium amount paid by the purchaser.
Options can be used in a variety of ways to profit from a rise or fall in the market. Buying an option offers limited risk and unlimited profit potential. Selling or writing an option, however, provides an obligation to perform if the party purchasing the option chooses to exercise. Selling or writing an option therefore presents the seller with limited profit potential and significant risk unless the position is properly hedged. Sellers or writers of options typically expect the price of the underlying security to remain flat or move in the desired direction. In return for their obligations, the writers receive an upfront cash payment or premium from the buyers.
Options are traded on securities and commodities exchanges and through the over-the-counter (“OTC”) market. With respect to the trading of options on exchanges, the securities exchanges generally list and trade options on stocks, exchange-traded funds (“ETFs”), bonds, trust issued receipts, other securities and foreign currencies. Commodity exchanges generally list and trade futures contracts and options on futures contracts. Options directly based on an underlying security or securities are solely listed and traded on securities exchanges.
Standardized terms for exchange-traded securities options include size, expiration date, exercise style and exercise or strike price. The creation of the Options Clearing Corporation (“OCC”) when standardized securities options trading commenced in 1973 virtually eliminated counterparty risk (i.e., the risk that the other party will breach the contract). OCC is the sole issuer and financial guarantor of all securities options traded by U.S. securities exchanges. In connection with the mechanics of listing standardized options contracts, the OCC together with the U.S. options exchanges have developed a nomenclature for describing different options as “options classes” or “options series.” The term “option class” means all option contracts of the same type of contract covering the same underlying security. The term “options series” means all options of the same class listing identical terms, including the same expiration month.
There are two types of standardized or exchange-traded options—calls and puts. A call option gives the holder the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time period in exchange for a premium amount. The buyer of a call option hopes the price of the underlying security rises by the call's expiration date, while the seller hopes that the price of the underlying security remains flat or decreases.
A put option gives the holder the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time period in exchange for a premium amount. The buyer of a put option hopes the price of the underlying stock decreases by the expiration date, while the seller hopes the price of the underlying security remains flat or increases.
The strike price is the fixed price of the option contract at which the underlying security can be purchased (call) or sold (put) at any time prior to the option's expiration date if the option is exercised. The expiration date designates the last day on which an option may be exercised. Standardized or exchange-traded options typically permit two (2) types of exercise: (i) American-style and (ii) European-style. American-style options can be exercised at any time prior to expiration while European-style can be exercised only on the expiration date. Exchange-traded options have an expiration month and generally expire on the third Saturday of the expiration month. A third form of exercise, which is occasionally used with over-the-counter (“OTC”) options, is Bermudan exercise. The Bermuda-style option can be exercised on several designated dates prior to expiration.
The premium amount represents the actual price an investor pays to purchase an option or receives for selling an option. The “bid” is the highest price a potential buyer will pay for the option while the “ask” is the lowest price acceptable to a potential seller. The “ask” and “bid” prices are known as “quotes,” which are disseminated by the options exchanges through the Options Price Reporting Authority (“OPRA”) with the difference between the bid and ask known as the “bid-ask spread.”
The pricing of options contracts is complex. The groundwork for the process of calculating a price for an option is set forth in the Black-Scholes Options Pricing Model (See Black, F. & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities,” Journal of Political Economy, 81, 637-654). Although developed in the early 1970's, this pricing model remains the basic pricing framework for option practitioners. In subsequent years, several variations from the Black-Scholes Options Pricing Model have been developed to directly address varying assumptions and scenarios. The major components affecting the price or premium are the current price of the underlying security, the type of option, the strike price compared to the current market price of the underlying security, the amount of time remaining to expiration, the volatility of the underlying security and interest rates.
The premium amount is generally the intrinsic value (strike price minus current value of the underlying security) plus time value. The intrinsic value of an option measures the amount that the option is “in-the-money” as compared to the strike price. The intrinsic value of a call option is thus the market price of the underlying securities minus the strike price of the option, and the intrinsic value of a put option is the strike price minus the market price. The time value portion of the premium depends on the volatility of the underlying security. Volatility is a measure of the amount by which an underlying security is expected to fluctuate in a given period of time. Options of stocks that are volatile generally require a higher premium due to the greater inherent risk.
Option contracts are a form of derivative instrument. A derivative instrument or derivative is a financial instrument which derives its value from the value of some other asset or variable. For example, a stock option is a derivative because it derives its value from the value of an underlying stock.
Derivatives are known or divided into two (2) types: plain vanilla and exotic. Plain vanilla derivatives generally provide for simple structures, while exotic derivatives generally provide for more complicated structures that are specifically tailored to an individual need, strategy, or situation. Accordingly, plain vanilla derivatives are typically more common and represent a greater share of the derivatives marketplace as compared to exotics.
Derivative instruments are further categorized in various ways. One distinction is between linear and non-linear derivatives. The former have payoff amounts that behave like a line, as shown in FIG. 1. The latter have payoff diagrams with curvature, either convex or concave, as shown in FIG. 2, or have more complex payoff diagrams, such as that shown in FIG. 3. In addition, a non-linear derivative may have gaps in the payoff profile.
Certain derivatives provide for the purchase or sale of an underlying asset. A typical standardized or exchange-traded option contract in the United States represents the right to purchase or sell 100 shares of an underlying asset. This type of option is typically said to have a multiplier of 100, i.e., the actual purchase price is determined from the quoted price multiplied by 100.
There is also variation in the method for settling option transactions. Options may be settled by delivery of the underlying asset (“physical settlement”) or by delivery of the cash value amount (“cash settlement”). A derivative instrument is physically settled if the underlying asset is to be delivered in exchange for a specified payment.
With cash settlement, the underlying asset is not physically delivered. Instead, the derivative settles for an amount of money equal to what the derivative's market value would be at maturity/expiration if it were a physically settled derivative (i.e. the intrinsic value), or for some other cash value determined by an agreed-upon method.
Certain types of derivatives are routinely cash-settled because physical delivery would be inconvenient or impossible. For example, an option on a portfolio or index of stocks, such as the S&P 500, will generally be cash-settled for convenience. An option on an interest rate must be cash-settled because an interest rate cannot be physically delivered.
One style of “exotic option” which is typically cash-settled is a binary option. Binary options (also known as a “digital options”) have a discontinuous or non-linear payoff, like that shown in FIG. 3. There are many forms, but the two most basic are: (1) cash-or-nothing and (2) asset-or-nothing. Binary options can be European or American exercise style and can be structured as calls or puts.
A European cash-or-nothing binary pays a fixed amount of cash only if it expires in-the-money. For example, a European cash-or-nothing call makes a fixed payment if the option expires with the underlying asset above the strike price. It pays zero (0) if it expires with the underlying asset equal to or less than the strike price. The value of the payoff is not affected by the magnitude of the difference between the underlying asset or index and the strike price.
Accordingly, binary options are clearly within the category of derivatives with non-linear payoffs. For example, a binary call option at a strike price for the underlying asset of 75 would pay the same amount if, at expiration, the underlying asset price was at 76, 80, 85, 95 or any other price above 75. In contrast, a standardized or exchange-traded call option in the money would pay different amounts based on each of those expiration prices, with the amounts increasing in a direct, linear relationship from the strike price.
Options are generally traded either OTC or on a national securities exchange registered with the Securities and Exchange Commission (“SEC”) or on a contract market designated by the Commodity Futures Trading Commission (“CFTC”). A registered national securities exchange or designated contract market are hereinafter referred to collectively as “organized exchange.” An instrument is described as trading OTC if it trades in some context other than on or through an organized exchange. OTC derivatives are understood to be specifically tailored to the needs and requirements of the end-user, and therefore, lack the standardization and transparency found on organized exchanges.
The majority of derivative products are traded OTC. In such a market, large financial institutions serve as derivatives dealers, customizing products for the needs of particular clients. Contract terms are negotiated between the parties, and typically each party has only their contra-party to look to for performance of the contract.
Binary options have been traded for some time in an OTC environment between institutional traders but not on a national securities exchange. Contract markets have offered “binary options” based on catastrophic events as well as on certain economic indexes such as the Consumer Price Index (CPI). In France, Germany and Austria, binary options have been traded OTC in a one-sided market between investors and an institution. The institution in these cases is the issuer of the contract and establishes, if applicable, the market for the binary option.
OTC binary options have several drawbacks and disadvantages. One disadvantage is that OTC binary options are typically offered by an institution on a non-fungible basis so that a customer can purchase the option only from the institution, and cannot easily resell to a third party because they are not standardized or traded on an exchange. As a result, OTC binary options, as compared to standardized exchange-traded options, lack important attributes of a trading market such as transparency and liquidity.
An example of the organizational structure of an exchange such as those on which some options are currently traded is illustrated in FIG. 4. Customers 410, through their broker/dealers 415, can offer to buy or sell an option. Organized exchanges typically facilitate the trading of options through a combination of electronic systems for order routing 420, matching 435 and execution and/or floor-based auction trading conducted using an “open outcry” method, by which competing floor brokers representing public orders and market makers trading for their own accounts, make bids and offers on the trading floor. Typically, in the floor-based model, trading takes place at a “post” consisting of a “specialist” 430 or designated market maker and trading crowd 425. The American Stock Exchange (“Amex”) employs a modified specialist system. The specialist post 430 is a specific location on the trading floor of the Exchange designated for the trading of a specific option class. Each option traded at a particular post is managed by an assigned specialist. A specialist is an Exchange member whose function is to maintain a fair and orderly market in a given option class. This is accomplished by managing the limit order book and making bids and offers for his own account in the absence of opposite market side orders, i.e. providing continuous two-sided markets. Other options exchanges have similar structures for trading options, whether electronic or on-floor.
By law, standardized equity options traded in the United States may only occur on a national securities exchange registered with the SEC. Options traded on national securities exchanges are generally traded based on an underlying equity or index meeting approved listing standards that have an appropriate pricing mechanism. For example, stock options are traded during the normal hours of operation of U.S. securities exchanges.
All standardized options in the United States are issued, cleared, settled and guaranteed by the Option Clearing Corporation (“OCC”) 445. This organization is equally owned and supported by all U.S. options exchanges. The OCC is able to recognize, segregate, calculate and disseminate information from the various exchanges, and to facilitate the fungibility described above in large part due to the standardized symbology scheme detailed below. Systems for calculating delivery and payment amounts due between participating parties rely on this standardization.
Options that are traded on national securities exchanges are standardized, and therefore fungible through the use of identical contract terms (such as expiration cycles) and pre-defined parameters. For example, all non-FLEX exchange-traded securities options expire on the Saturday following the third Friday of any given month. The issuer of each option contract is the OCC regardless of where the option trades. A writer of a standardized option cannot create or choose a different expiration date. The writer cannot change or define any strike price, but for any given option, must select from a specific set of available strike prices. Similarly, not all expiration months are simultaneously available for all standardized option series.
One convention that is central to the standardization of options is an agreed-upon scheme by which all options exchanges assign and attach symbols. The convention allows for options to have symbols with a maximum of 5 characters. Each character has 26 possibilities, corresponding to the 26 letters of the alphabet. The first one, two or three characters (known as the root symbol) denote the underlying asset for the option. In some cases this corresponds exactly to the underlying asset's trading symbol, in other cases there is no relationship between the two. The next character/symbol denotes two pieces of information—whether the option is a put or a call, and the month of expiration. These codes are listed in table I. The final character denotes the strike price for the option. The strike price codes are listed in table II.
TABLE IExpiration Month CodesNext-to-last Character - Expiration Month CodesMonthCallPutJanuaryAMFebruaryBNMarchCOAprilDPMayEQJuneFRJulyGSAugustHTSeptemberIUOctoberJVNovemberKWDecemberLX
TABLE IIStrike Price CodesLast Character - Standard Strike Price CodesCodeStrike PricesA5; 105; 205; 305; 405; . . . B10; 110; 210; 310; 410; . . . C15; 115; 215; 315; 415; . . . D20. 120; 220; 320; 420; . . . E25; 125; 225; 325; 425; . . . F30; 130; 230; 330; 430; . . . G35; 135; 235; 335; 435; . . . H40; 140; 240; 340; 430; . . . I45; 145; 245; 345; 435; . . . J50; 150; 250; 350; 450; . . . K55; 155; 255; 355; 455; . . . L60; 160; 260; 360; 460; . . . M65; 165; 265; 365; 465; . . . N70; 170; 270; 370; 470; . . . O75; 175; 275; 375; 475; . . . P80; 180; 280; 380; 480; . . . Q85; 185; 285; 385; 485; . . . R90; 190; 290; 390; 490; . . . S95; 195; 295; 395; 495; . . . T100; 200; 300; 400; 500; . . . U7½; 107½; 207½; 307½; . . . V12½; 112½; 212½; 312½; . . . W17½; 117½; 217½; 317½; . . . X22½; 122½; 222½; 322½; . . . Y27½; 127½; 227½; 327½; . . . Z33; 133; 233; 333; 433; . . . 
Generally, there are several expiration months available for each equity option. Moreover, there are several strike prices available for each expiration month of each option. Therefore, for a single stock there are often several options series traded and it is not unusual to have 60 different options series available for a single stock or options class. Thus, it will be apparent that for each options class, there may be several option series, each of which are separately priced.
For example, assume PQR Corp. is a publicly traded stock with the trading symbol of “PQR” and an assigned options root symbol of “PQR.” A typical option for this stock might be a PQR October 70 Call. A PQR October 70 Call option is a contract giving the holder the right to buy 100 shares of PQR Corp. stock at $70 per share until the third Saturday in October The symbol for this standardized option is PQRJN. Thus, by referring to the above symbology scheme, all interested parties recognize this symbol as denoting an option for the underlying asset PQR (derived from the first three characters in the symbol—PQR), which is a call option expiring in October (denoted by the “J”), with a strike price of 70 (denoted by the “N”).
This five (5) character symbology is an industry-wide convention for the processing of standardized exchange-traded options contracts. Options that cannot be made to fit within the 5 character symbology cannot be exchange-traded, because current industry systems only recognize the 5 character symbology. Accordingly, the only non-FLEX exchange-traded or standardized options contracts tradable on U.S. securities exchanges until now have been the traditional calls and puts described above. All other option styles, including European-style binary options, have traded OTC, where systems and processes are more flexible and can be made to recognize and accept a vast scope of varying option contract terms, and where a symbology scheme does not exist to limit product scope.
For current standardized options, at expiration a determination is made as to whether the option expires in-, at-, or out-of-the-money. This is determined by establishing an agreed-upon definitive settlement closing price for the underlying security, which is compared to each strike price to determine if the settlement closing price was greater than, equal to, or less than the strike price. With current standardized options there are standardized procedures that are followed to determine the settlement closing prices. For example, for traditional put and call equity options, the OCC determines the settlement closing price by taking the last reported composite trade at the close of trading, i.e. 4:00 p.m. Eastern Standard time. For index options, the designated reporting authority (i.e. the index provider), as defined by the particular organized exchange, performs the necessary calculations to derive a settlement closing value and then transmits that value to the OCC 445. The OCC then compares the settlement closing value to existing strike prices to determine which options are in-, at-, or out-of-the-money. In the case of some index options, this value is calculated not by looking at any one price of any one index or security at any one particular time, but rather is derived by taking a volume weighted average price (VWAP) of underlying securities over a designated period of time.
Standardized call and put equity options traded on the options exchange require a holder to tender exercise instructions in order for the option to be exercise or not exercised at expiration. For the purpose of convenience, the OCC, as issuer, has implemented an “Exercise-by-Exception” procedure which will exercise an option without specific exercise instructions if the option is in-the-money by the exercise threshold amount or more. The exercise threshold amount is [$0.25] per share in-the-money for customer accounts and [$0.15] per share in-the-money for firm and market maker accounts. The exercise threshold amount effectively triggers an automatic exercise. The application of the “Exercise-by-Exception” procedure will occur in all cases except where a holder of an option delivers contrary instructions. Binary options or “Fixed Return Options”SM (“FRO”SM or “FROs” SM) are automatically exercised under the terms of the contract, and therefore, the affirmative obligation to tender instructions as well as the “Exercise-by-Exception” procedure is unnecessary. This feature significantly differentiates FROs from traditional, exchange-traded options.
It has long been recognized that in order for a market to remain viable, participants must have a level of comfort and trust that they are transacting in a “fair” environment. Organized exchanges in the U.S. operate under specific legislative mandates to maintain “fair and orderly” markets. Since the adoption of the Securities Exchange Act of 1934, which created the SEC, particular focus has been paid to ensure that markets are not susceptible to manipulation. The SEC was created in part to stem the specific practice of “gaming” or manipulating stock prices such as was done by “short sellers” leading up to the stock market crash of 1929. Market fairness and integrity is a necessary underpinning of any market, as well as in the trading in any particular product or security upon any market.
The exact price at which any security closes on any given day can have important consequences. As discussed above, the closing price of an underlying security prior to expiration of an option has particular importance, as it is that value which dictates whether the option closes in, at or out-of-the-money. Accordingly, significant regulatory and surveillance efforts are employed by organized exchanges, self-regulatory organizations (SROs) and other regulatory bodies in an effort to detect, deter and eliminate potential manipulation of an underlying security that is near an option strike price at expiration.
Tremendous liquidity has been achieved in the exchange-traded options market, largely the result of standardization. The primary benefit of standardization and the reason for the tremendous liquidity is the interchangability or fungibility of option contracts regardless of where the option was originally executed. As a result, multiple contra-parties may exist. In the OTC markets, this benefit does not exist. In the case of multiply-listed or multiply-traded options (option classes listed and traded on more than one options exchange), standardization makes it possible to purchase an option contract on one exchange, and then sell it on another. Binary options have never been traded on a national securities exchange in a standardized form. There is a need in the art to provide liquidity in the binary options market, and there thus exists a need in the art for systems and methods for trading binary options on an exchange in a standardized form.